Evaluating a Validator
Why Jurisdiction Matters for Delegated Proof of Stake
Blockchain systems are a fundamentally new class of economic organisms. They are decentralized entities that exist entirely in cyberspace, maintained by a combination of cryptography, applied game theory, and consensus.
In blockchain technology, systems like Ethereum represent a new breed of decentralized entities that exist solely in cyberspace. A combination of cryptography, economics, and social consensus upholds these entities.
Delegated Proof-of-Stake (DPoS) networks, including Cosmos, Tezos, Livepeer, and Horizen, rely on on-chain governance to ensure their integrity. The effectiveness of the block producer vetting process plays a crucial role in maintaining the network’s strength and mitigating issues such as missed earnings and slashings for delegators.
For Cosmos, a decentralized network comprising interoperable and scalable blockchains, it becomes essential for delegators to optimize their staked Atoms’ returns by reducing costs and optimizing staking returns. Entrusting staked Atoms to a poorly vetted validator can result in financial losses and other undesirable consequences for delegators. The level of due diligence that delegators dedicate to vetting a block producer correlates directly with their net yield.
When evaluating a validator on the Cosmos network, there are key metrics to consider:
1. Reliability: The percentage of time the validator is online.
2. Efficiency: Does the validator often miss blocks?
3. Data security measures implemented by the validator.
4. Experience and ability of the validator’s team.
5. Validator’s cash position.
6. Jurisdictional risk.
Jurisdictional risk, in particular, holds significance for delegators. The jurisdiction, referring to the corporate domicile or primary place of business, plays a role in determining contractual obligations and the extent of government control.
A blockchain network transcends national, state, provincial, and economic union boundaries. Validators can have their offices and nodes located anywhere worldwide. When the validator and delegator reside in different countries, the principles of contract and ownership may vary. Even within the European Union, slight differences can arise. The disparities become more significant when a delegator in the U.S. interacts with a validator in Russia.
From a delegator’s perspective, it is ideal for both the validator and delegator to reside in the same stable and progressive legal jurisdiction, offering clear rules of law, property rights, and corporate transparency. If such an optimal situation is not possible, both parties should be domiciled in similar jurisdictions and minimize the geographic distance between them.
Contracts are vital in assessing a node’s reliability as a validator on the Cosmos blockchain network. Evaluating jurisdictional risk becomes a part of the delegator’s fiduciary responsibility as they establish favorable and enforceable terms within the off-chain contract. At the very least, a validator is contractually obligated to execute the blockchain and not abscond with the stake faithfully.
Authoritarian Governments
When assessing jurisdictional risk, it becomes crucial to consider the operating environment for validators in countries hostile to blockchain innovation. An example is the Chinese government’s temporary ban on blockchain mining in 2018. In theory, similar actions could be taken against PoS validators.
Malicious Governments
While still hypothetical, there is a theoretical risk of state-level malicious actors attempting to disrupt block producers within their jurisdictions. These actors may enforce censorship of specific transactions or coordinate with others to carry out malicious actions. Venezuela serves as an illustration of this potential jurisdictional risk.
Securities and Fintech Regulation
Validators are subject to regulations specific to securities and fintech industries, including reporting requirements. If regulatory actions in a validator’s jurisdiction make it commercially unviable to maintain regulatory approval or if operating or distributing tokens becomes illegal, a Cosmos block producer may cease its operations.
While some jurisdictions, such as the United States, Canada, Malta, Hong Kong, Singapore, and parts of the EU, have stringent licensing requirements and regulatory clarity, this cannot be assumed universally. Regulatory risk encompasses federal, provincial, and cross-border laws and regulations relating to consumer protection, data privacy, and other areas. These laws and regulations and their interpretation and application are subject to change. The enactment of new laws or regulations can significantly impact the utility of tokens and the operation of a blockchain platform.
Taxes
Uncertain or unstable tax regulations can have a detrimental impact on a company’s operations. Changes in a validator’s tax status or the introduction of new tax legislation can affect the value of their financial holdings and cap table. This may impact their ability to produce blocks at a steady rate consistently. Validators need to consider the potential impact of tax-related regulations on their business.
Conclusion
Several essential considerations exist as the DPoS blockchain ecosystem evolves, including jurisdictional factors. While the current user experience for voting and delegating on DPoS networks may be cumbersome, the Cosmos community’s efforts to address these challenges are still limited. The inclusion of governing law and jurisdictional clauses to provide legal certainty for delegators is an area that requires more attention.
Ranking validators based on jurisdictional risk and liability can be a valuable metric to consider during selection. However, defining rules and applying them in a decentralized environment presents its own set of challenges. Nevertheless, the involvement of knowledgeable individuals and services capable of evaluating jurisdictional merits and risks could significantly contribute to the stability and success of the Cosmos network.
Tools like Hubble, provided by organizations such as Figment Networks, offer delegators a ranking system to aid in choosing validators based on their performance and stake accumulation on the Cosmos network. While Hubble focuses on objectively measurable criteria, subjective and self-reported metrics like jurisdictional details are not currently tracked. Third-party auditing to verify such claims would take a lot of work to implement.
The choice of validators in specific jurisdictions may carry varying degrees of risk regarding block approval accuracy. Monitoring this metric closely and assessing its impact over time is essential. A diverse distribution of validators across different geographic locations, hosting and energy setups, and regulatory/legal jurisdictions has the potential to strengthen the Cosmos ecosystem. By considering jurisdictional factors and other metrics, delegators can make informed decisions prioritizing the security and optimal returns on their staked assets within the DPoS ecosystem.
Article by Jay Derenthal
